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Finance: ON April 7,
Governor Patton signed into law the Kentucky Investment Fund Act. The Act repeals the
Commonwealth Venture Fund, a well-intentioned, state-run venture capital program that,
unfortunately, failed to raise a single dollar for Kentucky businesses.
With this enactment, Kentucky joins a host of other states that seek to attract private
capital investment for in-state entrepreneurial activities through state-initiated venture
capital programs. While these types of incentive programs vary from state to state,
Kentucky has chosen to grant tax credits to private investors in exchange for their
capital investment in certified private investment funds that, in turn, invest in rapidly
growing and expanding Kentucky small businesses.
The centerpiece of the Act is a state tax credit equal to 40 percent of the investor's
certified capital contribution to a certified investment fund. Kentucky may authorize up
to $20 million in state tax credits over a 5 1/2 year period ending on December 31, 2004,
which could result in some $50 million of private capital invested in Kentucky small
businesses. All tax credits must be certified by the Kentucky Economic Development Finance
Authority (KEDFA) and
thereafter monitored with the assistance of the Kentucky Revenue Cabinet.
The tax credit is nonrefundable and nontransferable. It is applied against Kentucky
individual and corporate income and corporate license tax for tax years beginning after
December 31, 1998.
Only 25percent of the certified tax credit can be used by an investor in any one taxable
year with the balance carried forward until fully utilized over a 15-year period. To
ensure a long-term commitment by investors, the Act requires that tax credits be
recaptured if an investor's capital is either redeemed or withdrawn from the certified
investment fund within five years after the investor's capital is certified by KEDFA. If
an investorıs tax credit is disallowed in this manner, the investor is required to pay
back to the Commonwealth the amount of the credit previously claimed plus interest
compounded at a rate of 2 percent per month.
Qualified investments
To receive tax credits, an investor, through the certified investment fund, must make a
qualified investment in one or more Kentucky small businesses. Individuals and businesses,
other than insurance companies and financial institutions, qualify as investors. A
qualified investment may take the form of either an equity interest (i.e., stock,
partnership interest, membership interest, etc.) or debt, with the qualification that at
least 50 percent of a certified investment fund's capital must be invested in equity or
long-term unsecured debt.
A small business is defined under the Act as any business that (1) has a net worth of $3
million or less, and a net income after federal income taxes for each of the two preceding
tax years of $2 million or less, (2) is actively and principally engaged in a qualified
activity within Kentucky after the receipt of a qualified investment, (3) has no more than
100 employees, and (4) has more than 50percent of its assets, operations and employees
located in Kentucky. To ensure that investors are not penalized for their investment in a
Kentucky small business satisfies only the qualified activity requirement and the
requirement that more than 50 percent of the business be located in Kentucky. A qualified
activity engaged in by a small business must include one or more of the following
activities: industrial, manufacturing, mining and mining reclamation, commercial,
healthcare or agricultural enterprise or agri-business. Qualified activities do not
include activities principally engaged in by financial institutions, commercial
development companies, credit companies, financial or investment advisors, brokerage or
financial firms, charitable or religious institutions, oil or gas exploration companies,
insurance companies, residential housing developers, or retail establishments.
The investment fund is the vehicle into which qualified investments are made. However,
before an investor can secure tax credits under the Act, the investment fund, its
investment manager(s) and the fundıs cash contributions from investors must all be
certified by KEDFA.
This certification process begins on July 1, 1999 and ends on December 31, 2003 with
respect to investment funds and managers, and on December 31, 2004 with respect to cash
contributions.
An investment fund is any entity organized by an investment fund manager that is created
in accordance with applicable state securities laws and certified by KEDFA. The investment
fund manager must be an individual or entity who is authorized to act in this capacity by
the applicable state securities regulator and who has been certified by KEDFA to manage
one or more certified investment funds.
The investment fund's operations are subject to various requirements. First, the
investment manager must transfer at least $1 million into the certified investment fund
within 90 days after certification and any excess certified capital within one year from
such date. Second, the total qualified investment made by a certified investment fund in a
single small business cannot exceed 25 percent of the fund's certified capital. Third, the
certified investment fund must invest its certified capital (exclusive of the fund's
administrative fees and expenses) in qualified investments in accordance with the
following schedule: (1) at least 25 percent during year two; (2) at least 50 percent
during year three; (3) at least 75 percent during year four; (4) at least 90 percent
during year five; (5) at least 75 percent during year six; (6) at least 50 percent during
year seven; and (7) at least 25 percent during year eight. Finally, the total tax credits
certified by KEDFA for any single investment fund is $4 million, which limits the
certified capital over the life of a certified investment fund to $10 million. An
investment fund is not prohibited from raising capital in excess of $10 million, although
only the first $10 million is cash contributions will be eligible for tax credits.
An investment fund is prohibited from making a qualified investment in a small business
that is deemed to be the "alter ego" of the investment fund or its manager(s).
Consequently, a qualified investment cannot be made in Kentucky small business where (1)
the business is owned, in whole or in part, by an investor, director, officer, etc. of the
fund or its manager, (2) the business employs, on a full- or part-time basis, an investor,
director, officer, etc. of the fund or its manager, or (3) an investor, director, officer,
etc. of the fund or its manager has a direct or indirect financial interest in the small
business, other than through the investment fund's qualified investment. An investor,
director, and/or officer of an investment fund or its manager may, however, participate in
the management of the small business if the fundıs investment is in jeopardy or KEDFA
consents to such participation.
If at first you don't succeed...
The Act represents the Commonwealth's second attempt to address the capital needs of
Kentucky entrepreneurs. The Act breaks from the past and now relies on the interplay among
private investors, private investment funds and their managers, Kentucky small businesses
and the Commonwealth. While the Commonwealth continues to play a role in the development
of Kentucky small businesses, the Act has customized the process to provide greater
latitude to the investor by reducing governmental involvement.
On its face, a tax credit equal to 40 percent of an investor's capital will most likely
catch the attention of both venture capital funds and Kentucky small businesses. There is
no doubt that by using tax credits to leverage private investment, the Commonwealth can
provide Kentucky small businesses with an additional source of capital at a lower cost.
However, the question that remains is whether the economic (i.e. the tax credits) and
possibly the social (i.e., investing in Kentucky business) benefits of a program such as
this will stimulate and sustain the venture capital investment in light of the inherent
costs and expenses that are required to be incurred up front and on an ongoing basis in
order to comply with the provisions of the Act.
EDITOR'S NOTE:An edited version of this article appeared in Business First of
Louisville.
James C. Seiffert and Brian A. Cromer are partners at the law firm of Stites &
Harbison.
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